Source: Nick Petri – Market Research Analyst, OpenView Venture Partners, Wikipedia
Less than six months ago, Groupon was cruising towards a monster initial public offering. Expected by analysts to value the company in the $20-25 billion range, it would place Groupon neck-and-neck with Google’s valuation when the search giant went public nearly a decade ago. While the business model certainly had its fair share of nay-sayers, the future looked undeniably bright for the company and its employees. Revenue growth was outstanding, the customer base was emphatically loyal, and investor demand for “hyper-local” companies was red hot.
Then it all went wrong.
Today, about four months after the company filed their S-1 with the SEC, they’re still preparing for the IPO, and the expected valuation is less than half what they’d originally forecast. That’s a loss of more than 10 billion dollars. Even worse, some critics believe the company has to raise money to avoid a self-fulfilling liquidity crunch. Whether or not these critics are correct, one thing is certain: the company severely mismanaged what could have been a historic initial public offering. Here’s where they went wrong, and how to avoid making the same mistakes:
Questionable Non-GAAP reporting metrics
Groupon’s first controversy was its aggressive use of non-GAAP accounting in promoting the IPO to investors. Ideally, non-GAAP metrics are used to supplement a company’s SEC-sanctioned reporting and provide a more accurate picture of its ongoing profitability. But they can also be abused. In Groupon’s case, investors were thrown off not only by the aggressiveness of Groupon’s non-GAAP accounting, but also by the prominence management placed on one particular fairy-tale metric: ACSOI. Groupon eventually axed ACSOI, but the perceived damage to management’s integrity was already done.
The metric amortizes marketing and acquisition costs over several accounting periods. The “Adjusted” part of the metric increases (“inflates”) a company’s reported net income in the most recent accounting period. The rationale behind the use of ACSOI is that marketing and subscriber acquisition expenses have value long into the future: they build a brand; therefore, they should be spread out over time. Cash spent on marketing is not expensed: it is converted into another asset (“subscriber acquisition assets, net”) on a company’s balance sheet.
This presentation of net income is prohibited by the Financial Accounting Standards Board, arbiters of GAAP (Generally Accepted Accounting Principles) in the United States. In GAAP, marketing expenses may be accrued in some situations as prepaid expenses, but only amortized in special cases. Deferred acquisition costs are typically only allowed for amortizing the acquisition costs of customers in businesses like insurance, where the amortization occurs over the well-defined duration of a contract. ACSOI can be a useful internal metric for businesses to determine financial performance and to make strategic management decisions, if they believe their subscriber acquisition costs are an up-front cash outlay that truly builds long-term customer assets commensurate with that outlay. A main argument for not using this metric in GAAP accounting is that there is a key difference between subscribers and customers: customers make purchases and generate revenue for the business; it may be faulty to assume that all subscriber acquisition costs can be amortized as assets if only an unknown portion of the acquired subscribers will actually convert to customers.
Solution: There’s nothing illegal or wrong about using non-GAAP metrics, but glossing over unflattering GAAP measures will give the impression that you either don’t care about traditional reporting methods or are trying to hide them, both of which are major red flags. The better solution is to be up front and honest about poor GAAP earnings, but provide a clear roadmap of how you expect them to improve in the future.
“Leaked” memos during quiet period
During the SEC-mandated quiet period leading up to an IPO, management is limited in what they can say to the press about their company. CEO Andrew Mason has been accused of circumventing these laws by sending belligerent and defensive internal memos to thousands of Groupon employees, which were promptly and predictably leaked to the media.
Solution: Again, more damaging than the penalty of the crime, which is typically just a delay in the IPO, is what it implies about the maturity of its perpetrator. CEOs of public companies face a constant barrage of criticism from the financial media, and self-restraint in responding to this criticism is extremely important for a public executive. By recklessly firing back, Mason showed a lack of self-control that can land the firm in serious hot water if it becomes a pattern. Don’t make your first impression with the SEC a negative one.
The accounting restatement
There’s only one thing worse for your IPO than using overly-aggressive non-GAAP reporting, and that’s using overly aggressive GAAP reporting. On September 22, Groupon struck over $1 billion of previously reported revenue from its books. The mountain of greenbacks in question was money that had indeed passed through Groupon, but was immediately paid out to merchants, and therefore should have been deducted from net revenues. While the adjustment resulted in zero tangible damage to the company or its bank account, the investor fallout was disastrous. Like many promising but currently unprofitable companies, Groupon’s valuation was based principally on its revenues, and a 50% drop in its revenues had a nearly equivalent effect on its valuation. Perhaps even more damaging was that it rekindled accusations of misleading accounting that had begun with the ACSOI fiasco.
Solution: While young companies often have to make major accounting adjustments to comply with GAAP standards, the time to do this is before the IPO filing, when changes are expected and there’s much less scrutiny. Investors will expect you to be on top of your game by the time you file for an IPO.
In reality, many executives are nervous about their companies’ prospects and keep their eyes peeled for an opportunity to cash out on their success. Most management teams, however, can at least fake enthusiasm by hanging onto their shares until the IPO. Not Groupon’s. While the company has raised over $1 billion in venture financing, the vast majority was distributed to its employees and founders in exchange for their ownership in the company. Combined with the accounting issues, some are concerned that management is aggressively pumping up the stock to investors while quietly bailing out. Whether or not this is actually their plan, it’s not a good look for Mason and his lieutenants.
Solution: Cashing out will never look good, but if your integrity is at all under question, it’s especially important to be financially committed to the company.
Management changes are par for the course at a young company, but too many in too short a period of time can be a surefire sign of trouble at the top. Since filing for the IPO, Groupon has lost its COO (only five months into his tenure) and its head of PR (only two months into his). Stock market investors like continuity and they don’t like surprises, and too much turnover in the management team can have a tangible effect on the company’s finances. It can also signal that the problem might rest in the people who are still there, not the ones that left.
Solution: Simple. Don’t file until you have a stable management team.
Despite all of its flaws, Groupon has a lot going for it. Its revenue growth is phenomenal, and it’s the market leader in a hot market where size definitely matters. Perhaps they’ll be able to rebound and salvage a successful IPO, even if it’s somewhat smaller than they’d originally imagined. Perhaps they were just unprepared for the intense scrutiny and pressure that accompanies the decision to go public. Perhaps Andrew Mason will take the lessons he learned during the ordeal and flourish in the limelight of the public markets.
But regardless of how this turns out, they’ve set the standard for how NOT to manage an IPO. There’s a time and a place for sweeping changes to your organization and belligerent emails to your employees, and it’s not when you’re preparing for your IPO. Investors are looking for a stable and mature management team with a clear vision of where their company is going and how to get there. Most of all, they’re looking for someone they can trust to lead it. In the past four months, Mason and his team couldn’t convince investors that Groupon is ready for the major leagues. This week’s investor roadshow gives them one more opportunity.
The use of ACSOI came under scrutiny in August 2011, when it was revealed the company Groupon used the metric to present a net gain in operating income in their IPO filing. Without the ACSOI metric, Groupon would have stated a net loss.
- ^ “Groupon’s Innovative Accounting: Why CSOI Makes Sense”. Proformative. Retrieved 08/10/11.
- ^ De la Merced, Michael J. (2 June 2011). “What is Adjusted CSOI?”. New York Times. Retrieved 08/10/11.
- ^ Pepitone, Julianne (10 August 2011). “Groupon updates IPO filing, admits it’s unprofitable”. CNN.